Wednesday, March 6, 2013

Getting Schooled By Career Education Corp

The for-profit education sector has been hit hard by the market, and for good reason. This industry utilized dishonest marketing practices and drove its enormous growth using massive amounts of federal funding that was rubber stamped by public servants asleep at the wheel. But the party's now over; new rules and additional oversight have pushed many companies in this sector into the red, causing massive losses. But has the market overreacted? Perhaps in some cases. For example, Career Education Corp (NASDAQ: CECO) trades at a 43% discount to its net cash position!

While CECO has produced losses over the last couple of years, it has managed to avoid burning cash at a similar rate. Many of the company's losses can be attributed to asset impairments along with Goodwill and intangible write-downs. Future losses in some of the company's segments also appear unavoidable, but consider that in a year where the company had to adjust to a much lower revenue environment (due to drastically new regulatory compliance requirements), CECO's operating cash flow used only $17 million in 2012. Compare this to the company's $320 million net cash position (all cash less all debt) and $180 million market cap!

Management appears focused on stemming the losses by cutting non-profitable programs. Cuts initiated in the fourth quarter are expected to yield savings of over $50 million per year. In addition, the company has stopped marketing a number of its programs, choosing instead only to maintain operations required to teach existing students (so-called "teach outs"). Undoubtedly, this will have an effect on revenue; but these are likely unprofitable programs that were either eating cash or not generating decent returns on capital.

Admittedly, the earnings outlook for this company is murky, and there's no growth on the horizon. But CECO may make sense as a balance sheet investment if the losses are indeed curbed. With a tangible book value of about $400 million, the equity investor is paying just $180 million for a company with a strong net cash position that has time to turn things around and is currently aggressively cutting costs. Other companies in this space are also beaten down, but don't trade at this massive discount to net cash. Apollo (NYSE: APOL), Corinthian (NASDAQ: COCO), ITT (NYSE: ESI), Strayer (NASDAQ: STRA), and DeVry (NASDAQ: DV), for example, all trade at premiums to cash, and in many cases substantially so!

There are some caveats of which investors need to be aware, however. Much of the tangible book value is made up of computer hardware/software, furniture and leasehold improvements, which are of little value if operations turn further south. But it's difficult to tell just how much these components are included as property, because depreciation numbers aren't broken down by type of capital item.

Another worry is the company's litigation situation. This company has made a lot of enemies over the years. It is being sued by students, investors, employees, the federal government, and state governments. If that wasn't enough to scare you, there is also an SEC investigation that is ongoing, and the Education Department is conducting an inquiry concerning violations of misrepresentation regulations. All of the events causing these issues occurred when this was essentially a different company; nevertheless, the liabilities are very real.

A good portion of the company's cash is also spoken for in the form of deferred revenues. As revenues fall, as they certainly will as "teach-outs" are implemented, some of this spoken-for cash will disappear and not get replaced.

Finally, the company also has a number of operating leases expiring way out into the future. These total almost $640 million, though the company is working on trimming this number. Another downturn in operations, or a lack of ability to meaningfully cut costs, would make these fixed costs loom large.

Unfortunately, estimating the final cost of these liabilities is difficult to impossible. As such, this company is far from a sure thing, discount to cash or not. Nevertheless, it is clear that Mr. Market is trading this company as if it has no future. The company's substantial cash holdings, however, suggest the upside to such an investment is higher than the downside is low. Each investor will have to come to his own conclusion about the return profile of this investment.

What do *you* think?

Disclosure: No position


Anonymous said...

I think it is surprising how HIGH the stock is trading for...

Don't let the numbers fool you.

This company has tremendous customer concentration. In fact, I would guess that ONE customer accounts for well over 90% of revenue!

Who is that customer? Why the federal government of course. When you look at the revenue the school receives, 90% is from student loans. Student loans originated or guaranteed by the government.

There are SERIOUS problems with the student loan situation. If CECO has too many delinquent loans, they don't qualify to get any more...

HOWEVER, current regulations are a joke...Do you want to bet your investment that regulations are NOT going to be tightened?

Additionally, there is an unbelievable amount of problems from the lawsuits. These are not frivolous suits either...

Another problem is how incredibly damaging to students this industry is. An argument can me made that the "for profit" education industry is largely a wealth transfer from taxpayers to the corporations with students getting crushed in the middle.

Before anybody invests in "for profit" education I would suggest going to the Google and searching "subprime comes to education". The results will show article after article about the antics of this industry. There are articles by the New York Times, Forbes, LA Times, The Telegraph, Washington Post, and many other credible publications.

I doubt this industry will survive in it's present form...

Anonymous said...

Yes, CECO trades at a discount to cash but it also has liabilities. So simply saying it has $X per share in cash doesn't account for these liabilities.

Anonymous said...

I prefer COCO in the space. Good commentary and analysis here:

g-mo said...

Total cash = $402M
Total liabilities = $511M
Net cash = $(109)

This isn't a net cash stock. I'm at a loss for how you came up with $320M.

Saj Karsan said...

Hi Garrett,

I actually defined net cash in the article itself!

" cash position (all cash less all debt)..."

This definition makes sense in the same way as net debt isn't just debt less all assets.

Hi Anon3,

COCO does look interesting, I agree. But I do fear they may have to do a substantial capital raise to meet regulatory requirements, so I would worry about getting quite heavily diluted.

Anonymous said...

Excellent point on COCO Saj,

One thing is for sure with COCO: Expect volatility.

The ED will either continue supporting COCO's title IV elgibility due to the restated 2011financials, and current compliance


The ED will make an example of them mafia style, sending the shares in the toilet as they violate debt convenants, and are forced to scramble for cash however they can.

Given the run rate FCF they will generate if the title IV funding continues, I believe the risk/reward is favorable...but high.

I like the odds due to the forecasted Pell Grant surplus, and superior economics of a loan model (even with high defaults) vs the outright subsidy model of public ed. Particularly due to the states' cash strapped budgets, and clear shortage of skilled people that COCO and similar schools train. The only option left seems for profit. While a complete loss of capital is obviously possible, I think it is a favorable bet.

Certainly not for someone who doesn't like the possibility of losing the whole sum comitted.I'm long the equity, but the binary style outcome may also offer an opportunity in the calls (As outlined by Greenblatt). The downside is potenitally similar ie. 0, but the upside could be greater. Just a thought.

Thanks for the response, and keep up the good work!

Anonymous said...

To the first comment, the subprime situation cannot be compared to the student loan situation. 80% of the credit risk is carried by the federal government, and about 90% of the balance has co-signers taking on the risk. I'm not arguing that things aren't going to fall apart in the industry, but it is not a subprime situation.

Anonymous said...

To 3/10/13 at 11:21 PM:

Sure, student lending is very much like the subprime housing situation.

They are giving out loans to EVERYBODY with almost no underwriting criteria.

The government will loan you money to literally study ANYTHING! It does not matter if you can get a job.

So there is no value to the collateral (possibly excepting the co-signers). There is also no underwriting standard.

Perfect ingredients for inflating a bubble...